Three Roth IRA tax traps to avoid

Friday - 5/14/2010, 10:45am EDT

Ed Zurndorfer, registered employee benefits consultant

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By Suzanne Kubota
Senior Internet Editor
FederalNewsRadio.com

After weighing the pros and cons, before you decide to convert a traditional IRA to a Roth IRA, Ed Zurndorfer, registered employee benefits consultant, told Federal News Radio there are three basic tax traps you need to know about.

Starting out, said Zurndorfer, there are two basic ways to get a Roth IRA in the first place. You can contribute (assuming you're eligible and your income is below a certain level) or take an existing IRA and convert it to a Roth IRA. Anybody can do it, said Zurndorfer.

Unfortunately, anyone can run afoul of tax traps too, "and I can tell you, a lot of people are falling into these traps right now because they're getting bad advice or they're not... following the rules that the IRS is putting out."

Name a Beneficiary

If you convert, you name a beneficiary.

Otherwise, if someone gets your Roth IRA through a will instead of being named the beneficiary on the account, they have to take the money out of the account within five years. "But," wrote Zurndorfer in a recent article, "if the individual was instead named as the Roth IRA beneficiary, then the individual could withdraw the account over his or her life expectancy, possibly resulting in a lifetime stream of tax-free payments."

"It doesn't really cost you anything," said Zurndorfer. "It's just a matter of filling out another form."

Zurndorfer said he tells his clients with both conventional and Roth IRAs to fill out the beneficiary form.

Partial Roth IRA Conversions

"Many people have several IRAs," said Zurndorfer. When converting, you can't pick and choose which one to convert based on how much tax you think you would otherwise pay on that account for the year, because the IRS looks at all the money in all the funds. Or as Zurndorfer writes, "when there is a conversion of a nondeductible IRA, a pro-rated amount of after-taxed money is included with each dollar converted."

TSP Rollovers

Another potential tax trap for federal employees can occur when a retiring employee rolls over monies from the TSP to a traditional IRA in the same year that the retiring employee makes a Roth IRA conversion. Note that only IRA assets fall under the 'pro-rata" rule. Retirement plan assets- this includes the TSP - have no effect.

Any money coming from the TSP that is rolled over to what they call a rollover IRA has never been taxed, and if the individual converts another IRA, some of which has already been taxed, you're going to end up paying tax on the whole thing because the fact that you rolled over money from the TSP, really in a sense, decreases your cost basis in those other IRAs which will result in a higher tax bill.

So Zurndorfer recommends federal employees who decide to rollover their TSP into a traditional IRA do that AFTER they convert any traditional IRA to a Roth IRA.